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Watching bonds

The US yield curve tells us how to invest. And for now at least, it is telling us to be optimistic about equities and cyclical stocks
Watching bonds

US interest rates are going up. Futures markets expect the fed funds rate, which is now 2.2 per cent, to rise to almost 3 per cent by the end of next year. They believe this largely because the Fed has told them to do so. It has said that if growth and inflation turn out as expected it will raise the funds rate to just over 3 per cent by next December. Whether we should worry about this – and what we should do about it – depends heavily upon how bond markets react.

I say so for a simple reason. The yield curve (the difference between long-term and short-term interest rates) predicts recessions. When it inverts – with long yields below short ones – a recession follows. And if it doesn’t invert, growth continues.

My chart shows the point. It shows the gap between 10-year yields and the fed funds rate, lagged three years, plotted against the three-yearly change in US industrial production. The link might not look especially strong. But this is because the relationship takes a particular form. When 10-year yields fall below the funds rate, a recession follows: this happened in 1989, 1999-00 and in 2006-07.

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